Thursday, October 23, 1997
Leave That 401(k)
Alone
by David M. Grimm
([email protected])
Have you ever considered borrowing money from your 401(k) plan? If you are planning to take out a consumer loan (i.e., non-deductible interest for tax purposes), at first blush borrowing against your 401(k) sounds like a very Foolish way to borrow. After all, you are borrowing from yourself and you pay yourself back with interest at a competitive rate. At my company, we can obtain the loan with a simple phone call to Vanguard (the plan administrator) and the payments are handled through payroll deduction.
My wife and I decided to take a trip this year to celebrate our tenth wedding anniversary. I hate taking money out of regular savings because, despite my best intentions, I always have a hard time paying myself back. Instead, I borrowed from my 401(k) plan because my employer does not make repayment optional; it is required by the terms of the plan. This, I thought, was being very Foolish.
But let's put pencil to paper (or cursor to spreadsheet) and see what the real cost is. For simplicity, assume you borrow just $1,000 and it remains outstanding for exactly one year. At the end of the year, you pay back the loan with interest at 8%, resulting in earnings of $80. Now, let's compare that $80 to what you would have earned on the $1,000 if you had left it in the plan. At the historical Dow 30 rate of 13.3%, earnings for the year would be $133 (a difference of $53); and at the historical Foolish Four rate of 22.91%, earnings for the year would be $229 (a difference of $149).
A Fool knows that the real difference is not just $53 or $149, but is instead what that money would have compounded to over the years until it was withdrawn from the plan. After 30 years, your $53 at the historical Dow 30 rate would have compounded to $2,245. But if the returns in your 401(k) plan approximate the historical Foolish Four rate, your $149 would have compounded to $72,578. In other words, that one-year $1,000 loan could end up costing you more than $70,000 at your retirement!
Next time you are thinking about borrowing from your 401(k) plan, think again. It may not be very Foolish.
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